Exchange Traded Funds

An exchange traded funds, or EFT, might best be described as a hybrid between a share of common stock and a mutual fund.  In fact, because of the way EFTs are structured, they present some interesting options to both the novice and seasoned investor.

Defining an Exchange Traded Fund

Generally, EFTs are portfolios of securities (just like a mutual fund) that are actively traded on a stock exchange (just like a share of common stock).  When first introduced, exchange traded funds attempted to duplicate a commonly-known and well-respected market index such as the NASDAQ 200 or the S&P 500.

Today EFTs provide investors with a much wider selection of investment options including currency, gold or silver, and even commodities and natural resources such as oil, natural gas, and other energy products.  Even with all of this diversity, exchange traded funds share some common characteristics including:

• They are listed on a stock exchange and traded continuously.
• They can trade at a discount or premium to total value of all assets held within the EFT.
• They are typically based on some well-known stock index or are well-defined with respect to the allowable investments.  This keeps turnover and other fund management costs low.

Benefits of Exchange Traded Funds

Since they are traded just like common stock, EFT investors enjoy their flexibility of trading in the stock market.  For example, you can invest in shares on margin, short sell shares, or take a long-term position.  Investors would purchase and sell these funds just like common stock - through their broker - and shares in EFTs are traded throughout the trading day.

Limiting Market Risk with EFTs

Exchange traded funds also provide the investor with the ability to purchase a portfolio of stocks, thereby eliminating individual stock risk.  They are also designed to be efficient because just like a mutual fund index they are not actively managed.  The portfolio is only adjusted, or balanced, to contain the right mix of the index it is mirroring.

These funds do, in fact, enjoy a robust trading market.  The NASDAQ 100 tracks some of the fastest growing technology companies listed on that exchange.  There is a NASDAQ Index tracking stock, QQQQ, which is the most actively traded fund of this kind in the world.  The latest statistics indicate that over 90 million shares of this fund are traded daily.

So recapping, it seems that exchange traded funds offer all the benefits of a mutual fund index fund but add the flexibility of stock trades - which is quite attractive to investors.  But not so fast, there are some big disadvantages of these funds that are worth mentioning too.

Disadvantages of Exchange Traded Funds

Just like common stocks, you will need to pay a brokerage commissions on the shares traded.  And unlike most mutual funds, you might also be hit with embedded fees that can eat into your return on investment.

For example, many funds sell at a bid - ask spread.  Meaning you might purchase shares at $10.125, but selling is occurring at $10.000.  These funds don't always sell at the Net Asset Value (NAV) of the underlying portfolio, so trades could take place at prices above or below the value of the assets.  This is referred to as selling at a premium or discount.

Because of these commissions and underlying fees, a mutual fund index generally supplies superior returns to the investor.  If you are making small, monthly purchases of an EFT, the commissions will significantly impact the investor's total return.

Federal Tax and EFTs

Due to SEC regulations, there is a small tax advantage EFTs have over mutual funds, however, if you're purchasing shares for a non-taxable account, such as a 401(k) account or an IRA then this advantage does not apply.

For example, mutual funds in the United States are required to realize a capital gain that is not necessarily balanced by a loss.  For example, as new shares of an open-ended mutual fund are created or destroyed via purchases and redemptions, the fund managers are forced to purchase and redeem shares of stocks that make up the fund on the open market.

The SEC requires all mutual funds to distribute capital gains to all the fund's shareholders each quarter, which can have some undesirable capital gains tax implications to your federal income tax return.  Since EFTs are not redeemed by shareholders but exchanged on the open market, the only time capital gains taxes come into play is when that individual shareholder closes out their position.

Top EFTs on the Market Today

We're going to finish this article on exchange traded funds up by providing a list of some of the more common / popular funds on the market today as determined by daily trading volume.  These funds have been broken down into two categories:

• US Index-Based EFTs
• Commodity-Based EFTs

The two tables below contain the fund names, stock ticker symbols as well as the daily trading volume (November 2007):

US Index-Based EFTs

Commodity-Based EFTs

About the Author - Exchange Traded Funds

Bill Sharlow is the Editor of Money-Zine.com.  Copyright © 2004 - 2007 Money-Zine.com

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